Tobin's Q Ratio

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Tobin's Q Ratio

A ratio of a company's market value to its total asset value. Tobin's Q ratio is based on the work of James Tobin, who suggested that a fairly priced company ought to have a price equal to its total asset value. Thus, when Tobin's Q ratio is less than one, it means that the market value of the company is less than the total asset value, indicating that it is undervalued. Likewise, when it is more than one, it indicates that the market value is higher than the total asset value and that the company might be overvalued. Tobin's Q ratio is also called simply a Q ratio.

Using superior replacement cost data and several parametric and nonparametric tests, we show that (1) average and marginal Q ratios are significantly different, and (2) using an average measure as a decision variable for capital investment leads firms to an incorrect investment decision approximately fifty percent of the time.

Average Q ratios are preferred due to their comparative ease of computation.

If the firm is a price-taker with constant returns to scale in both production and installation of assets, then marginal and average Q ratios are equal.

Table 1 shows the estimated average and marginal Q ratios and the announced percentage change in investment by firm.

We conclude that, on average, the marginal and average Tobin's Q ratios differ for firms in the sample.

47 Table 1 Estimated Tobin's Q Ratios and Announcements by Firm Average Q is calculated as the ratio of the market value of the firm to replacement cost.

Tobin argues that firms have an incentive to invest when the marginal Q ratio is greater than one since capital equipment is worth more than it costs to replace.

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